Wednesday, November 7, 2012

I have an obsession with dividend stocks. I log-on to my brokerage accounts every morning, in order to check the amount, timing and source of any dividends deposited. On certain days, such as the 15th of some months, the amount of dividends received is much higher than my salary. To me dividends represent financial freedom from a 9 to 5 (or typically later) job.

Dividends are an integral part of my retirement strategy. The point at which I will be able to retire will be when distributions exceed my monthly expenses by a sufficient margin of safety at the crossover point. I do not blindly invest in dividend stocks however. I follow a multi-step process, in order to ensure that unnecessary risks are not taken along the way.

A long time ago, employees used to slave away for 3 – 4 decades, until they received the golden watch at their retirement party. Typically starting at the age of 55, retirees were able to draw upon their company’s defined benefit plan. A few years later, they were able to receive Social Security checks, and live comfortably for the rest of their lives. A few decades ago however, corporations started cutting retirement benefits, and instead offering optional defined contributions plans, such as 401K’s. There is much speculation that the age for receiving social security benefits will be increased going forward, and that the amount of the benefit might be reduced in the meantime. This means that employees should be relying on themselves for funding of their needs in retirement.

Many retirees are typically sold on traditional asset drawdown schemes such as the four percent rule. This rule was popularized by CFP William Bengen in his research studies. According to this strategy, investors would purchase bond and stock index funds, allocate them in their portfolios according to their risk preferences. Investors will then sell a portion of their portfolios each year, in order to pay for their lifestyle, while rebalancing their portfolios and paying their financial planners and mutual fund managers sizeable fees in the process. The issue with this strategy comes when retirees are experiencing prolonged flat or bear markets. People who retired in 1999 – 2000 or in 2007 have been selling off portions of their portfolios, while the investments in their portfolios have remained flat or declined in value. If the market keeps being flat for another decade, these people will certainly run out of money and enjoy a much lower standard of living in the process. To me, selling off a portion of my assets each year is akin to cutting the tree branch you are sitting on.

This is one of the primary reasons why I am sticking to a strategy, where my portfolio throws off a decent amount of cash every month, quarter or year. This way, I maintain ownership in the companies I hold, without risking selling stocks for income during flat or bear markets. No matter what the markets do, as long as I have selected fundamentally strong companies, my dividend checks will keep coming in the mail.

In order to ensure that my portfolio will generate a rising stream of dividends every year during my planned retirement, I need to follow several sound principles around diversification, entry criteria and stock analysis.

Diversification is important, because it ensures that I do not have all of my eggs in one basket. In my portfolio, I attempt to hold at least 30 individual securities, which are representative of as many sectors as practical. That way, if all the companies in a certain sector cut dividends all at once, the impact on my overall dividend income will be negligible.

Entry Criteria at which stocks are purchased is important as well. I am currently dollar cost averaging my way into attractively priced stocks every single month. I try not to pay over 20 times earnings, an attempt to buy companies that yield at least 2.50% these days. Once a stock I own sells at more than 20 times earnings or less than a 2.50% yield, I will hold on but would not add to the position. In addition, I purchase securities which have sustainable dividend payments, and which have established histories of consistent dividend increases.

Diversification and entry criteria are closely interwoven with my overall analysis of a security. There are always at least 15- 20 attractively priced dividend stocks to purchase each month, which is why I need to do a little work before determining which stocks to add. I would need to also analyze each company in detail, in order to determine whether it can provide dividend growth in the future. This is achieved by studying the business, reading financial statements, visiting locations, talking to suppliers and customers and staying up to date on major developments. While I am enjoying the rising stream of dividend checks, I also want to see my dividend stocks deliver capital gains over the long run as well.

I take a conservative view of dividend investing, because I do not want to learn how to greet customers in my late 70s or early 80s. Some companies which I have recently met my entry criteria include:

McDonald's Corporation (MCD) franchises and operates McDonald's restaurants in the global restaurant industry. The company has raised dividends for 36 years in a row. Over the past decade, this dividend champion has managed to boost distributions by 27.40% per year. McDonald's currently trades at 16.40 times earnings and yields 3.50%. (analysis)

Aflac Incorporated (AFL), through its subsidiary, American Family Life Assurance Company of Columbus, provides supplemental health and life insurance. The company has raised dividends for 30 years in a row. Over the past decade, this dividend champion has managed to boost distributions by 20.40% per year. Aflac currently trades at 8.30 times earnings and yields 2.80%. (analysis)

Chevron Corporation (CVX), through its subsidiaries, engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. The company has raised dividends for 25 years in a row. Over the past decade, this dividend champion has managed to boost distributions by 8.80% per year. Chevron currently trades at 8.90 times earnings and yields 3.30%. (analysis)

Air Products and Chemicals, Inc. (APD) provides atmospheric gases, process and specialty gases, performance materials, equipment, and services worldwide. The company has raised dividends for 30 years in a row. Over the past decade, this dividend champion has managed to boost distributions by 11.10% per year. Air Products and Chemicals currently trades at 14.40 times earnings and yields 3.30%. (analysis)

Walgreen Co. (WAG), together with its subsidiaries, operates a chain of drugstores in the United States. The company has raised dividends for 37 years in a row. Over the past decade, this dividend champion has managed to boost distributions by 18.90% per year. Walgreen currently trades at 14.40 times earnings and yields 3.20%. (analysis)

6 comments:

Dividends can and do go down in times of financial crises. Once the stock prices fall to a certain point, the dividend yiled looks very attractive but then after a few cycles the company may cut the dividend.

Great article. I began a dividend growth investing program 2 years ago on my 40th birthday as a gift to my future (and ultimately my family's future). The math works in the long term, of that there's little doubt. The challenge is human nature, lacking patience and the constant barrage of information which can easily and repeatedly take a person off course. Discipline is the key.

I'm wondering what you think will happen with dividend tax rates in the near to mid term (2-5 years), the president has already pledged to raise taxes on dividends and capital gains.

We started dividend investing about 3 years ago and we are quite please with our progress thus far, however if dividend tax rates edge up significantly I fear we will see a large number of dividend cuts as a result.

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